Can U.S. Stock Rally Continue?

Investors are bucking the general trend of gloominess pervading the national audience, sending stocks to their highest level in four years last year, and if history is any guide, prices could soar even higher by the end of the year.

Even as election season grinds on and a majority of voters say they believe the country is moving in the wrong direction, investors are flocking to riskier assets - the ones that tend to come back first in a recovery. The edgier parts of the U.S. stock market, including small cap stocks and stocks with higher beta, have rallied since the market bottomed in early June, soundly beating the broader market. Historically, this kind of confidence has ultimately lifted the entire market, pointing to gains by the end of the year, according to Sam Stovall, chief equity strategist at S&P Capital IQ.

What do investors know that voters don't? They're hoping that the end of the Euro crisis is at hand. Last week markets across the globe rallied when the ECB announced a plan to support the ailing Euro. The S&P 500 climbed more than 2%, to its highest level since the 2009 bottom. Stovall said that since 1945, whenever the S&P 500 has recovered fully from a drop of 5?0%, it notched median gains of 4.6% and mean gains of 7.8% in about three months. So, if the historical norm holds, the S&P 500 could end the year between 1500 and 1550.

However, Stovall doesn't believe every trend will keep on track. He said that he thinks the small cap rally, up 14.2% since June 1, may well slow. He points to an outsized gap in valuation between small- and large-cap stocks, noting that eight of 10 S&P small cap sectors are beating their large-cap equivalents (except for financials and technology).

Here are the numbers: The S&P 500 is now trading at a multiple of 14 times this year's price-to-earnings estimate, compared with a multiple of 19 for the S&P SmallCap 600. Since 1995, (as far back as the data goes), the S&P 500 has sported a median 18.2 price-to-earnings multiple, compared with a median 21.4 price-to-earnings multiple for the S&P 600.

The difference between large caps today and their norm is 30% - a much bigger gap than the 7.5% gap for small caps. Stovall admits that the current trend is all about riskier, smaller stocks, but writes, "the relative valuation of the small-cap stocks to the large-cap group will likely keep their advance in check."